Capitulo 17: FROM THEORY TO MALPRACTICE LESSONS LEARNED

Box A. Operational Risk, One of the recurring lessons of the derivative debacles recounted in this book is the daunting nature of operational risk — that is the risk of catastrophic loss (often due to unauthorized trading) associated with internal processes, faulty models or computer systems, derelict employees or external events. Unlike market or counterparty risk for which insurance products or derivative markets offer comprehensive protection operational risk cannot be easily hedged. Indeed there is a scarcity of insurance products providing coverage against operational risk: one exception is Swiss Re — one of the largest re-insurance company in the world — which offers “financial institution operational risk insurance" to protect against unauthorized trading (rogue traders) and other types of operational risk. In the same vein and recognizing its importance

Basel II is mandating a new operational risk charge as part of regulatory capital imposed on financial institutions.

exposure) which are consistent with the firm´s appetite for risk. This presupposes that the Board of Directors has set clear strategic objectives and risk tolerance parameters within which risk management policies can be formulated and implemented. Defining the firm's risk appetite is one of the cornerstones of a risk management strategy: It rests squarely with the firm's senior management which will decide on its level of risk-aversion and therefore how conservative its risk management strategy will be. It will also shape major risk taking decisions: for example setting a certain level of credit rating for the firm as a risk management objective will constrain the risk-return tradeoffs within which investment decisions will have to be made. Last but not least senior management must also insure that such policies be woven into the fabric of the firm's daily operations. A word of caution though: as we argue for tighter risk management rules the firm has to make difficult trade-offs:

A company's risk management function could, at least in theory, be designed to know everything at all times, But if it were organized that way, the risk management function, besides being hugely costly, would likely stifle innovation and reduce the competitiveness of the firm. In fast moving markets, employees need flexibility.

POLICY RECOMMENDATIONS FOR NON-FINANCIAI, FIRMS

Derivatives are a key risk management tool used widely by non-financial firms. The acid-test for any use of such instruments — and for that matter any risk management policy — is whether they are truly value-creating for the firm. The evidence provided in this book clearly indicates otherwise. Derivatives debacles which involved non-financial firms were rooted in ill-devised financial engineering (Metallgesellschaft), non-authorized speculative trading (Allied-Lyons), misunderstood products (Proctor & Gamble) and concealed losing speculative trades (Showa Shell).

Upon closer scrutiny of the above cases a simple taxonomy of corporate vulnerability to the malpractice of derivatives can be presented in a matrix which — on one dimension — will distinguish whether firms set up their treasury as a profit center and — on the second dimension —- whether treasury operations rely mostly on over-the-counter (OTC) derivatives as opposed to exchange traded products (see Table 1).

As the book amply illustrated failure to set clear and unambiguous objectives for the treasury office compounds the firm's vulnerability to derivatives' malpractice (see lesson #1 below). Most non-financial firms are better off keeping their treasury operations as a nonprofit center unless they developed unique expertise in a speculative market — e.g., energy companies in gas or oil derivatives. When treasury is set as a profit center it is important to clearly delineate the proprietary trading activities from traditional treasury operations and to set very tight monitoring guidelines for the newly embedded "hedge fund."

Reliance on OTC products also compounds the firm's exposure to debacles because enforcing positions and more importantly trading loss limits requires an inhouse marking-to-market algorithm (sec lesson #2 below). The absence of any cash margin requirements for OTC products (margins are the hallmark of exchange traded products) makes it casier to conceal large positions from the firm's comptroller.

Lesson 1: Failure to Set a Clear Mission for Treasury as a Profit Center.

A company's treasury department is charged with two principal tasks: (1) procuring financing at the lowest possible cost of capital with financing running the gamut from

short-term suppliers' funding in the form of account payables from suppliers to medium and long term bank loans or various forms of capital market debt and (2) hedging risk by limiting the firm's exposure to exchange rate, commodity price and interest rate risk in a manner consistent with its risk appetite. Neither funding nor hedging are profit making activities per se since the goal of financing is to minimize costs while hedging is all about minimizing risks. And yet many corporations have in the last 25 years redefined the mission of their treasury operations to turn them into profit centers.

For example, with the overhauling of its treasury function as early as 1987 Allied- Lyons' treasury seemed to have morphed into a de facto profit center without ever articulating clearly the risk-return profile within which it could operate. Indeed Allied-

Lyons had reported increasingly significant profits from foreign exchange trading and success clearly emboldened its treasury to pursue high stakes currency gambits. Profits came from the firm taking on sizeable speculative positions to which the governance of the firm seemed to acquiesce. Unfortunately, there was no charter prepared by the treasury, supported by the finance director and debated before being blessed by the Board of Directors. Speculation within the treasury was no secret and the alarm bells did ring on a number of occasions without any formal attempt by senior management to rein in the treasury's activities. Similarly Procter & Gamble was committed to lowering its cost of capital through creative financial engineering courtesy of Bankers Trust: unfortunately it exposed itself foolishly to risk that it failed to fully comprehend.

Lesson 2: Failure to Enforce Position and Trading Loss Limits. When it comes to the effective use of derivatives the trading room all too often happens to be the Achilles' heel of the firm. Most trading rooms within large industrial or financial institutions have reporting guidelines in place with tight net position and trading loss limits. Allied-Lyons claimed to have had position limits of £500 million which were easily circumscribed by Bartlett and his acolytes. Similarly Showa Shell had a $300 million trading limit. In both cases position limits were not monitored nor enforced.

Position limits are actually not enough and should be superseded by more revealing trading loss limits which can be enforced by a "marking-to-market" of each outstanding derivative product. Because forward contracts and over-the-counter swaps and options are not traded continuously — unlike futures and other exchange-traded derivatives — "marking them to marker would require careful valuation at the close of every business day. In fact a "shadow" margining system attached to OTC products would greatly enhance the transparency of the trading room. This can be readily done through the Interest Rate Parity theorem (in the case of foreign exchange), Cost-of-Carry formula (in the case of commodities), Black and Scholes model (in the case of options) and appropriate valuation models for interest rate, currency or credit default swaps.

Close monitoring of the trading room will further require that each trade, when executed, be recorded via a trade ticket with the "back-office" accompanied by its rationale. Presumably an industrial corporation such as Allied-Lyons or Showa Shell should primarily trade currencies paired with real transactions — that is transactions having to do with imports/exports of goods or services. This is known as the legitimate activity of managing transaction or translation exposures. More speculative proprietary trading — if tolerated as part of profit center mandate —— should be closely supervised with stress-testing of pessimistic scenarios accompanied by Value-at-Risk analysis and measurement. Unfortunately, at Allied-Lyons overly lax controls allowed currency traders to build an overall speculative position in excess of £1.5 billion which bore no relationship to the scope of its International operations. Similarly traders at Showa Shell built a mammoth dollar position in excess of $6 billion without senior management ever finding out.

Lesson 3: Failure to Report. When it comes to derivatives what to report, when to report and to whom to report are often questions ill addressed by large organizations.

A breakdown of aggregate derivative positions by tenor/maturity is necessary to avoid creative yet noxious speculative schemes as illustrated in the Citibank case. Reporting should be on a daily basis and reach not only Treasury's senior management, but also the very governance of the firm albeit on a less frequent basis. At Nippon Oil, Japan's largest oil refiner and a direct competitor of Showa Shell, the Treasury's deputy manager of foreign exchange was required to report to the company's Board of Directors at their monthly meeting on their foreign exchange positions and associated hedging policy.

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